How To Protect A Portfolio Of Financial Companies

Sectors are some of the factors that may influence the choice of going to cash, hedging, or doing nothing when entering a bear market. My previous articles of this series gave examples for consumer staples, industrials, healthcare, energy, materials and consumer discretionary (last episode here). This one will focus on the S&P 500 Financial sector.

For each sector in the S&P 500 universe, I defined a fundamental ranking process. My Financial Ranking is simple and uses only two fundamental factors. For the next part, I will use a strategy consisting of a 4-week rotation of the ten stocks of highest rank. It represents about 12% of the reference set: there are currently 81 financial companies in the S&P 500 index. This is not one of my investing strategies, but a model portfolio using common sense and simple fundamental factors. I find it more relevant than using a market cap-based ETF like XLF or IYF.

I have performed three 15-year simulations (1/1/1999-1/4/2014): without protection ("NP"), with market timing ("MT") and timed hedged ("TH"). The portfolio is rebalanced every four weeks. The timing indicator is the same for market timing and timed hedging. It is defined by a bearish signal when the S&P 500 current year EPS estimate falls below its own value three months ago, and a bullish signal when it rises above this value. The hedge is an S&P 500 short position in a 1:1 ratio with the portfolio value.

The unprotected portfolio gives an unacceptable drawdown and volatility. Simple market timing (going out of the market) cuts the return and risk-adjusted performance (Sortino ratio). Timed hedging doubles the Sortino ratio and boosts the annual return by one third. Here is the equity curve of the time-hedged strategy (in red) compared with SPY (in blue):

(click to enlarge)

This is a dynamic portfolio. On average, 2 stocks change every four weeks. Here are the three highest market capitalizations of the current portfolio:

Timed hedging is modeled here in a margin account, and margin costs are included. However, it can be executed without a margin account, by selling 25% of the portfolio and buying a 3x inverse S&P 500 ETF. It gives the same protection as shorting SPY in a 1:1 ratio.

Conclusion:

For at least 15 years, timed hedging was the best of these three tactics to maximize the return and limit the drawdown of a model portfolio in financial companies. If you don't want to miss the two last articles of the series, click on "Follow".

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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